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By Jason Stipp | 02-16-2011 12:12 PM

How Inflation Unravels Recoveries

Almost every economic recovery that has come to an end has done so because inflation has outstripped wages, says Morningstar's Bob Johnson.

Jason Stipp: I'm Jason Stipp for Morningstar.

We got Producer Price Index data this week, definitely showing signs of inflation in the market. Inflation is something that has been on a lot of investors' minds over the last few weeks.

Here with me to offer his take on the inflationary environment today is Morningstar's Bob Johnson, director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: So before we get into the nitty-gritty on some of the things you are looking at, let's talk about why inflation is such an important part of the economic cycle.

Johnson: Yes, and that's a really important thing to keep in mind, and many people don't realize it, but it's really inflation at the end of the day that ruins most economic recoveries. Almost every economic recovery that has come to an end has come to an end because inflation has outstripped wages, and therefore consumers can't spend as much. And then you start to break the demand cycle down, and since you have already had a little bit of overbuilding, things begin to collapse on themselves. So inflation, especially inflation exceeding wage growth, is really what does in most economic recoveries, and it is the single most important data piece to watch.

Stipp: Then on the flip side, when you are in the middle of a downturn, it's deflation that ultimately gets people to start spending again.

Johnson: That's absolutely what happened this time around. We had some major price decreases going on [in] the recession, and that caused people that were otherwise usually savers to say, "you know, I'm going to go out and buy that car that's 10% off of what I would usually have to pay."

So it's that phenomenon of getting people off the sideline with lower prices that got this recovery going, and [price levels are] going to be the very same thing that ends a recovery.

Stipp: So obviously this is why inflation-deflation figures are one of the main things on your radar. I know it's also part of the Fed's mandate as well to help manage inflation. But I'd like to take a step back and think about what are the arguments for inflation and deflation. It still seems like there are two camps out there. There is one camp that's saying there are a lot of headwinds against inflation that are going to keep prices lower. What's their argument, and is it still pertinent today?

Johnson: Sure, I think it is, and I think we've got to be careful not to take things to extremes. It's not either/or in terms of the camps. There is a little bit of a blend.

But the argument against inflation is that we have got a lot of slack capacity, especially labor capacity and industrial capacity here in the United States. And if we have all that extra capacity, how the heck can prices go up?

And in fact if prices on commodities, which are clearly going up--your cotton, your oil, your copper, are all clearly going up. Their argument would be, well fine, those things will go up, but as the price of gasoline goes up that means [consumers will] have to spend more on gasoline and therefore they'll cut back on their spending on something else, and that will make the price of that something else go down, and so, therefore, it's a self-correcting mechanism that you have got going there.

Stipp: So they are saying that balance will keep inflation in check.

So another thing is, some folks are saying the rampant inflation of the 1970s can't happen again for some structural reasons today. What's that argument?

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